The Legislature Extends Tax Incentives To Encourage Local Private Companies To Become Publicly Owned Corporations Until 2003. But Will That Be Enough?

by JEFFRY VALENTIN-MARI

Developing a native capital market - The government is intent on hiking the number of publicly owned local companies. But are the companies and the market ready?

Local companies and individuals invest huge amounts of money outside Puerto Rico. According to the latest Puerto Rico Planning Board figures, the value of local investment abroad swelled by $1.96 billion to $27.49 billion in 1999, in comparison to $25.53 billion in 1998.

That number continues to grow considerably. According to Rep. Angel Cintron, Chairman of the Federal and Finance Affairs Commission of the Puerto Rico House of Representatives and experts of the local financial industry estimates, the amount of money invested by local companies and individuals outside Puerto Rico may very well have surpassed $30 billion in 1999.

That reality is at the heart of government efforts to spur the development of a local capital market in Puerto Rico; to promote more of the islands economic bounty being reinvested here (see side bar).

"To assemble a capital market in Puerto Rico, one fundamental step is to develop specific local investment instruments, sufficiently attractive after tax to be competitive with the traditional investment instruments available off- island", Cintron told CARIBBEAN BUSINESS.

A key element of that broad initiative is to provide incentives for local companies to become investment vehicles for local investors, i.e., to go public by making and initial public offering (IPO) of their stock.

A major step in that direction was taken three years ago. Law 42 of 1997 was intended to stimulate capital investment in local companies, among other things. The most important aspect of Law 42 was that it reduced tax rates on capital gains made on the sale of shares from a local IPO from 20% to 7%.

Since its adoption, however, Law 42 has met only with mild success in motivating local companies to go public and is scheduled to expire on December 31, 2000.

But it has now gotten a new lease on life. House bill 1270, introduced by Cintron, was recently approved by the House after the amendments suggested by the Treasury Department and the Office of the Commissioner of Financial Institutions were incorporated. At press time, it was expected to be approved by the Senate this week and be sent to Fortaleza for the Governors approval.

The purpose of House Bill 1270 is to continue providing incentives to encourage the conversion of local private businesses into publicly owned companies. Actually only

Four companies have gone public since the 1997 law, primarily because few companies were ready in 1997 and, lately, because the stock market has changed so drastically.

Most importantly, the new bill extends the time "window" in which the companies can go public and benefit from the preferential tax rates on capital gains on the sale of shares from the IPO provided in the law until 2003.

The bill also clarifies the provisions in the 1997 legislation regarding the applicability of the preferential tax rates to certain transactions. Ironically, following a protracted battle with the local Treasury Department during the legislative process, the House Bill 1270 increases the preferential tax rates on capital gains from the current 7% to a still attractive 9% rate.

Although lawmakers are optimistic, many experts believe the conditions of the stock market and the lack of preparedness on the part of local companies make it unlikely that we will see the initials of more Puerto Rico companies on the stock ticker tape, at least before a year or two.

The market

The remarkable performance of the U.S. stock markets in the last decade has fueled a huge market for IPOs.

The number of IPOs in the U.S. has surged from just over 200 in 1990 to more than 600 in 1997, peaking at nearly 900 in 1996, according to figures provided by Ernst & Young LLP. Since 1970, IPOs have raised more than $340 billion, dramatically fueling technological innovation, greatly heightening economic productivity, and substantially rewarding large and small investors.

Perhaps most visible are the high flying Internet IPOscompanies like Yahoo.com, Amazon.com and eBaythat have achieved huge market capitalization in very short time. Market capitalization refers to price per share multiplied by the total number of shares outstanding.

Ironically, it is precisely the remarkable performance on the stock market that experts believe is the greatest obstacle for more Puerto Rico companies to go public any time soon.

Its largely a matter of size. Right now, investment banks and brokerage houses in New York wont even look at an IPO of less than $200 million. "Why should they take interest in structuring and placing smaller IPOs when they have dozens of IPOs from $200 million into the billions waiting in line, in which they can make substantially more money. Its crazy. There arent that many companies in Puerto Rico that can make an IPO in the $200 million-plus range, and those that could, may have other reasons for not going public," a source told CARIBBEAN BUSINESS.

Its also a matter of appetite. In the last few years, the individual and institutional investor in the stock market has developed an insatiable appetite for large capitalization technology stocks such as Microsoft, Cisco, Qualcomm, and Intel. Based on their remarkable performance, the market has more recently developed a hunger for the so-called dot-com stocks (like those of e-Bay, Amazon.com, AOL, and Starmedia)no matter the fact that most of these dot.com companies continue to lose money hand over fist and have no idea when they will start to make a profit. In fact, with the dot.com companies, the old way of valuing stocks time earnings has gone out the window. They have no earnings, so their value is now calculated times revenue and some are valued at over 1,000 times revenue with no profits in sight.

The proof is in the pudding. Since January 2000, the Dow Jones industrial average (an index comprising mostly blue-chip, brick-and-mortar stocks) has been struggling to stay above the 10,000 mark, while the Nasdaq (where many of the high-flying cap tech and dot-com stocks are traded) has been establishing new records. In fact, despite its recent slump, the Nasdaq had hit 5,048 in March.

With those market dynamics of investors lusting after high-flying technology and Internet stocks with skewed price/earnings ratios, its easy to see why the IPO of a local company would result unattractive.

Most of the largest privately owned companies in Puerto Rico are established firms in the retail, wholesale, financial, and service industries whose stock would not be attractive at this time even if their IPOs had the right size dollar offering and the companies were otherwise prepared to go public. They still could not compete for the stock market investors dollar. However, according to experts, these dizzying valuations of technology stocksespecially the dot.comsare starting to lose their attractiveness as investors are seeing more of these companies go out of business and others are just living off the capital they raised originally but still with no profits in sight.

Another factor that is affecting the market and, therefore, the likelihood of more local IPOs is the recent interest rate hikes.

In an effort to slow the torrid pace of the U.S. economy and ensure prices of goods and services dont flare out of control, the Federal Reserve Bank has increased short-term interest rates six times since June 1999. The most recent movement was last May 16 when the Feds policy-making arm, the Federal Open Market Committee, opted to lift interest rates by more than a quarter of point.

These increases have placed a downward pressure on the stock market generally and have sent the stock of many brokerage houses, banks, and other financial institutions tumbling.

"The Puerto Rico Stock Index (PRSI) has been taking a beating in the last two years. In fact, the PRSI edged down between 30% and 35% during 1999" Luis Miñana, First Vice President of Solomon Smith Barney told CARIBBEAN BUSINESS. The PRSI is an index of Puerto Rico-based stocks, which is heavily waited by financial stocks. Despite representing substantial increases in revenue and profits year after year, Puerto Rico public companies, which are mostly banks, are also being overshadowed by the technology sector.

With this in mind, its not hard to see why local companies who are potential IPO candidates have turned skittish and are waiting on the sidelines until the market starts turning its attention back to profitable brick-and-mortar companies.

Getting ready

Besides market conditions, there are other reasons that could explain why local privately owned corporations have not responded to the incentives implemented by the government to go public.

Before a company can sell itself to investors, it must put its affairs in order and present an appropriate aggressive business plan to investors. "This cannot be done in a day or a month: it needs long-term planning. In fact, there are several local private companies really interested in becoming publicly owned companies, but this is a process that requires some time for preparation", Joseph ONeill, Puerto Rico Commissioner of Financial Institutions, told CARIBBEAN BUSINESS.

"Furthermore, there are local private companies that are completely apprehensive about the auditing and public disclosure process that is required for a company to become a publicly owned corporation. This has had the tendency of limiting the number of companies willing to participate in the development of a native capital market through IPOs", ONeill said.

Although companies in Puerto Rico are required by law to file an audited balance sheet every year with the local State Department, the filing requirements of the Securities and Exchange Commission are considerably more onerous and revealing.

The SEC is a federal agency created by the Securities Exchange Act of 1934 to oversee compliance with federal statutes designed to promote full public disclosure of public companies businesses and their finances in order to protect the investing public against fraudulent and manipulative practices in the securities markets.

For one, companies are required to produce audited financial statements for the last three years of operation before they can go public. In addition, they are required to file quarterly reports with the SEC and the exchange they list on. They must also comply with state securities laws, National Association of Securities Dealers requirements, and several exchange guidelines. Even if these filing requirements did not exist by law, investors would be reluctant to invest in companies failing to supply thoroughly audited financial information. Furthermore, a company is legally liable for the information it provides.

Although no one would admit it on record, there is a consensus among business people in Puerto Rico that whatever the effect of the local requirement of filing audited financial statements, it does not preclude even large, reputable companies from often having dubious accounting practices.

"The first thing you have to do in order to go public is to get rid of the second set of books," a source told CARIBBEAN BUSINESS.

"This is one of the problems faced in efforts to increase the number of IPOs in Puerto Rico. If local private companies decide to go public, they need to clear up their record-keeping in order to meet the accounting requirements established by the SEC. This process may take several years. Despite having approved the IPOs incentives back in 1997, some local companies wont be able to go public until 2001 or 2002, because they need several years to get all this accounting procedure ready", Sen. Kenneth McClintock, Chairman of the Puerto Rico Senate Government Federal Affairs Committee told CARIBBEAN BUSINESS.

And even though there are many excellent, top-notch local accounting firms, getting ready to go public may require retaining a large international auditing firm or a large local firm affiliated with a national firm, whose name and reputation is well known in stateside financial markets.

Besides taking time, all this preparation costs money. Although the price tag for going public may vary depending on the size and complexity of the transaction, a company planning to go public should be prepared to spend a cool million or so in brokerage commissions, legal, accounting, printing, and filing costs, among others for an IPO.

Management also has to make a big investment of time in the process, which continues even after the company is public. Worse yet, the process of going public necessarily forces a company to disclose to competitors operational and financial information that would not otherwise be available to them. So, is it all worth it?

Why go public?

There are two basic reasons for a private company to go public: to finance growth or to cash out, i.e., turn the companys paper value to its owners into a liquid form, i.e., cash.

Besides its own retained earnings, companies have two options to finance their expansion: take on more debt or sell part of its equity either privately to individual investors or publicly through and IPO.

According to experts, many large companies in Puerto Rico who would be potential candidates for an IPO are so cash-richhaving accumulated capital over their lengthy existencethat they hardly need to sell their stock in order to finance their planned growth. Others with moderate levels of indebtedness may prefer to take on more debt than selling off equity, thus opening themselves to outsiders and risking losing managerial control of the company.

Thats the case of many family-owned businesses in Puerto Rico who are reluctant to go public fearing they will lose the tight control of the company and zealous of sharing profits with outsiders.

Going public, of course, does not necessarily imply losing absolute managerial control. In Puerto Rico there several examples of companies that have gone public and have successfully retained control of the company by either offering to the public only non-voting stock or retaining a controlling percentage of the shares in family hands.

"In Puerto Rico, the reality is that most privately owned companies that have plans to invest capital in their own business prefer to use their own money or to get loans. Local private companies are apprehensive of the conversion to a publicly owned company, where they have to share profits or reveal details of their business.. This mentality makes it difficult to increase the number of local IPOs", Arturo Carrion, Executive Vice President of the Puerto Rico Banking Association, told CARIBBEAN BUSINESS.

"It may be that many of these companies have not yet identified the investment opportunities. But there is clearly a need to educate local entrepreneurs to understand the benefits of going public", Carrion added

However, the process of going public has been very successful to some Puerto Rico companies. "For us, going public was an efficient and low-cost way of growing in the market," Mario S. Levis, executive vice president of Doral Financial Corp., told CARIBBEAN BUSINESS. "This process has facilitated our capacity to raise more capital not only in the U.S., but in the local market," Levis added.

Economies of scale

Finally, the relatively small size of the Puerto Rico market may be a limiting factor for any aggressive growth in the number of local public companies.

As one of the two main reasons for offering company stock through an IPO is to raise additional capital in order to finance the expansion of the companys operational capacity, the question arises how many companies in Puerto Rico may need the huge capital injection that results from and IPO in order to finance their projected growth.

With a limited market of approximately 4 million consumers, few retail, wholesale, or distribution companies need to raise, say, $50 million in an IPO in order to finance their growth in Puerto Rico (See sidebar).

"For most local companies, the decision of converting into a publicly owned corporation will depend on how comfortable they feel about their growth performance," Levis added.

In fact, many local private businesses dont have the need to raise additional capital by going public unless owners want to cash-out from the enterprise (to obtain liquidity for their retirement or their estate, for example) or expand to other markets outside of Puerto Rico.

Most experts agree that local companies have to expand their market outside Puerto Rico if they want to increase their economies of scale to a point where it might be worth to raise capital by going public.

This Caribbean Business article appears courtesy of Casiano Communications.
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